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IMF Credit Standing By in Turkey

Prime Minister Recep Tayyip Erdogan is weighing whether to accept fiscal discipline in return for an IMF credit.

For a nation that thought it had turned its back on economic turmoil, the current recession has been a rude shock. In the past year, Turkey’s economy has plunged even faster than it did during the financial crisis that devastated the country in 2001. Output fell by 13.8 percent in the first quarter from a year earlier, exports have dropped by nearly a third, and unemployment has shot up to 13.6 percent. Among countries in Central and Eastern Europe, only the Baltic states and Ukraine have been hit harder.

Yet Durmus¸ Yilmaz, the central bank governor, sees hopeful signs amid the wreckage. Turkey’s banks, which in 2001 needed a massive bailout financed by the International Monetary Fund, enjoy relatively robust health, he notes. They remain profitable and well capitalized, the percentage of nonperforming loans is in single digits, and the industry hasn’t needed any government subsidies or injections of capital, a stark contrast to the situation in many European countries. Thanks to the banks’ good performance, “recovery in Turkey will take place earlier than in our peer countries,” Yilmaz asserted in a recent interview at the Central Bank of the Republic of Turkey’s offices in Ankara.

Such optimism isn’t shared by many industrialists and financiers, however. Cos¸ kun Ulusoy, chief executive of military pension fund Ordu Yardimlas¸ma Kurumu, or OYAK, which owns the country’s most profitable conglomerate, sees little prospect of a rebound in growth for years to come unless the global economy takes off. “A strong banking sector is no guarantee if the world economy doesn’t fully recover,” he said over a recent lunch at an Istanbul restaurant. Many bankers, meanwhile, doubt that there is enough economic activity to support a significant increase in borrowing. “I am not seeing green shoots,” says John McCarthy, chairman of the Turkish branch of Dutch bank ING, one of the largest foreign banks in the country. What Turkey needs, most business executives and bankers agree, is a new agreement with the IMF to enforce fiscal discipline, stabilize the economy and ensure access to foreign credit.

Those calls pose a dilemma for Prime Minister Recep Tayyip Erdog˘an’s government. Erdog˘an has resisted an IMF accord for most of the past year because it would impose budgetary constraints that could tie the hands of his ruling Justice and Development Party, known by its Turkish acronym, AKP, ahead of parliamentary elections in 2011. Such a move could also tarnish the AKP’s reputation for economic competence. The party, which took power in 2002, helped lead Turkey out of the previous crisis and ushered in a six-year boom, with growth averaging 6.5 percent a year, by enacting sweeping economic reforms and opening membership negotiations with the European Union. As late as October 2008, Erdog˘an gamely insisted that the worldwide crisis had “bypassed Turkey.”

The deep recession has dented the government’s popularity, though. Voter support for AKP candidates tumbled to 39 percent in municipal elections in March, down from 47 percent in the 2007 national parliamentary elections. “The AKP has lost its smugness,” says Gülnur Aybet, a Turkish political analyst for the Southeast Europe Project at the Woodrow Wilson International Center for Scholars, a think tank in Washington.

The electoral setback has prompted Erdog˘an to change tack. In May he ordered a government shake-up that moved his Foreign minister, Ali Babacan, back to the Economy Ministry. Babacan held that post from 2002 to 2007 and oversaw a government reform program that slashed the budget deficit and encouraged an influx of foreign investment. He also pursued tax and pension reforms as part of a $10.8 billion standby credit agreement with the IMF, a deal that expired in 2008, shortly before the latest crisis hit. Now bankers and economists are hoping for a repeat performance from the 42-year-old minister.

“Babacan has a great track record. He was one of the most effective Economy ministers in the last four decades, so the business community has high confidence in him,” says Yarkin Cebeci, an economist at JPMorgan Chase & Co. in Istanbul.

Babacan has stepped up talks with IMF officials about a standby credit that could total as much as $45 billion, raising hopes for an accord. Erdog˘an himself fueled speculation in July when, after a meeting with IMF managing director Dominique Strauss-Kahn on the margins of the Group of Eight summit meeting in L’Aquila, Italy, he expressed hope that the two sides could reach agreement on a standby credit before the annual meeting of the IMF and the World Bank, which will take place in Istanbul in early October. But analysts say the government continues to balk at the kind of spending curbs that the IMF is demanding, restraints that Erdog˘an earlier this year termed “unacceptable.”

In the meantime, Babacan has moved to bolster revenue, raising excise taxes on tobacco and oil products and hiking the value-added tax on high-end restaurants that cater to tourists. He also promised a medium-term economic plan to balance the government’s primary budget, which excludes interest payments, by 2012. Delays in the plan, which was originally to be published over this summer, have raised doubts about the government’s resolve. “A few months have passed since Babacan’s appointment, and it is time for him to step forward,” asserts Mehmet Sami, an executive board member at Ata Invest, a leading Istanbul-based investment bank.

Compounding the government’s economic difficulties is the lack of progress in membership negotiations with the EU. Erdog˘an assumed power in 2002 determined to bring Turkey into the union and used that prospect to push through reforms ranging from the abolition of the death penalty to cracking down on corruption in government procurement to asserting civilian control over the military. Talks began with fanfare in 2005 and have been a major factor driving foreign investment in Turkey, but so far work has begun on only 11 of the 35 chapters — policy areas covering everything from competition to agriculture — needed to gain entry. France and Germany continue to oppose membership for Turkey because of its large Muslim population, even as the EU prepares to open fast-track membership talks with Iceland. Admitting Turkey would overextend the EU’s borders and mission, French President Nicolas Sarkozy said recently, adding that the bloc “must cease to dilute itself in endless enlargement.” Erdog˘an noted during a visit to Brussels in June, “There is indeed a discrimination there, and we are very saddened to see that.”

At the same time, tensions have flared up between Erdog˘an’s moderate Islamic AKP party and the armed forces, which consider themselves the guardians of modern Turkey’s secular traditions and have staged four coups in the last half century. In July, 56 people — including two retired generals — went on trial on charges of attempting to provoke a military coup through attacks on politicians, newspaper editors and judges, and President Abdullah Gül signed legislation allowing civilian courts to try military personnel.

Although the collapse of global trade over the past year has hit Turkey hard, many of its economic woes are homegrown. The country entered the global recession with the exceptionally high central bank interest rate of 16.75 percent, a legacy of efforts to control inflation after the 2001 crisis. “That had started taking a toll on domestic credit demand already in late 2007,” says Ahmet Akarli, a London-based economist for Goldman, Sachs & Co. In addition, the government channeled big spending increases to municipalities to build support for the local elections in March, causing the budget deficit to widen sharply. The country’s current-account deficit also exploded, to $41.6 billion, or 5.7 percent of GDP, in 2008, reflecting years of strong domestic growth and the surging prices of oil imports.

So when global credit markets seized up last fall after the collapse of Lehman Brothers Holdings, Turkey suffered an especially harsh blow. The lira plunged by 27 percent against the dollar in just five weeks, and the economy shifted abruptly into reverse. The IMF predicts that for all of 2009 output will drop by 5.1 percent, a more dire estimate than the government’s forecast of a 3.6 percent decline. JPMorgan Chase expects foreign direct investment this year to be only a third of the record $21 billion in 2007.

Notwithstanding the severity of the downturn, there are some encouraging signs. Steep falls in imports combined with lower oil prices are shrinking the current-account deficit; economists at JPMorgan Chase predict the gap will narrow to just 1.3 percent of GDP this year. That decline has taken pressure off the lira, which in mid-August was virtually unchanged since the start of the year, at about 1.50 to the dollar. The lira’s steadiness enabled the central bank to slash its benchmark interest rate by 8.5 percentage points, to 8.25 percent. “We have told the markets that, if needed, the central bank can take a number of further measures,” says governor Yilmaz. Inflation, meanwhile, remains subdued at a rate of 5.2 percent, a 40-year low.

Turkey is also benefiting from a revival of global risk appetite. The Istanbul Stock Exchange saw a rise of 63 percent between January and mid-August, second in the CEE region only to the Russian Trading System Stock Exchange, which recorded a 75 percent jump. Spreads on Turkish debt have also narrowed dramatically. The government sold $1.25 billion of eight-year bonds in July at a spread of 298 basis points over comparable U.S. Treasuries, down from 501.3 basis points on a January issue. The big questions for investors are whether the gains are being driven by expectations of an IMF accord and, if so, whether the revival of investor confidence will paradoxically embolden the government to eschew an agreement.

“The government believes it has done a lot in the past seven years to strengthen economic fundamentals,” says Akarli. “So there is a firm conviction that Turkey needs the IMF a lot less, regardless of global conditions.”

The government has few tools at its disposal to counter the sharp recession, though. Unlike China, with its massive monetary reserves, Turkey does not have many resources to stimulate the economy and combat unemployment. Although the government was able to cut the budget deficit to just 0.7 percent of GDP in 2006, that number edged up to 1.87 percent last year. Huge increases in spending since the beginning of the year led to a 5 percent deficit in May that is expected to reach 7 percent by the end of 2009, according to analysts at Eurasia Group, a New York–based risk consulting firm.

To finance the swelling deficit, the government is having to sell more bonds to the banks, crowding out credit available to businesses. That explains why industry is eager for the government to reach a new standby agreement with the IMF. “With the help of IMF funds, the Treasury will borrow less money from the market and leave more available for the private sector,” explains Fatma Melek, chief economist at Akbank, the country’s largest private sector bank.

Other bankers argue that an IMF agreement would be even more important as a confidence-building measure. It would signal to investors that the government accepts the need for fiscal discipline, and it could help bolster Turkey’s sovereign rating, which Standard & Poor’s and Fitch Ratings now put three notches below investment grade, at BB-. “No matter how good a company is, it is still stuck with the country’s rating,” says ING’s McCarthy. “So an IMF deal has an impact on the cost of funding for Turkish corporates and banks.”

But any such agreement would carry potentially severe political costs. It would require effective controls on Turkey’s municipal spending, currently the black hole in the government budget deficit, because municipalities have been allowed to spend with considerable independence yet with implicit Treasury guarantees. “This is where politicians deliver the aid and services that get them votes,” notes Goldman’s Akarli. “Losing control over the municipalities is a major concern for Prime Minister Erdog˘an.” The March election results stunned the AKP, which was defeated in 12 cities, including Siirt, the southeastern hometown of Erdog˘an’s wife, Emine. With much more at stake in the 2011 national elections, the prime minister is not moving to tighten purse strings.

Another key IMF demand — tax reform — also poses difficulties for the AKP. Turkey currently raises more than 60 percent of its revenue from indirect taxation, mainly value-added taxes. With the recession battering consumer spending, revenue has tumbled, contributing to the rapid increase in the deficit. The IMF wants a more balanced tax structure that gets a greater percentage of revenue from business, especially small and medium enterprises. But these family-owned firms are the AKP government’s main business constituency.

Turkey doesn’t need IMF help for its banks, though, which is a welcome contrast to the 2001 crisis. Indeed, the strength of the banking system is one of the biggest factors underpinning hopes of an economic turnaround.

The financial collapse at the start of this decade included a massive devaluation and a run on the banks that caused 31 of the nation’s 79 lenders to fail. Radical reforms and a $47 billion bailout have rebuilt the industry into a much healthier one. Turkish banks have created strong domestic deposit bases and reduced their dependence on foreign funding to less than 20 percent. They also boast an average capital-adequacy ratio of 18 percent, well in excess of the 8 percent minimum required under the Basel II accord. “Our regulatory agency, the Turkish Financial Authority, won’t allow any bank to open new branches if its ratio falls below 12 percent,” points out the central bank’s Yilmaz.

Net profits of the banks rose by 32 percent, to Tl 5 billion ($3.3 billion), in the first quarter compared with the same period a year earlier, reflecting higher interest margins.

Loan losses are nowhere near the problem levels of other CEE nations. Turkey continues to have low leverage; household debt is only 12 percent of GDP, compared with an average of 40 percent in CEE countries and 100 percent-plus in Western Europe. And in Turkey only 4 percent of consumer loans are linked to foreign currencies, in sharp contrast to the 50 percent-plus average for the CEE region.

Overall, Turkey’s nonperforming-loan rate stood at a manageable 4.6 percent at the end of June, up from the precrisis level of 3.5 percent. According to Yilmaz, even if the NPL rate rises to 20 percent, the capital adequacy of the banks will not dip below 12 percent. On average, banks have set aside reserves to cover 80 percent of NPLs, and that figure is higher at the leading banks. “We were aware of the rising risk already in late 2007 and have fully provisioned all of our NPL portfolio,” says Akbank’s Melek. Akbank, which is 20 percent owned by Citigroup, posted an 8 percent rise in net income in the first half of this year, to Tl 1.31 billion.

Still, the banks can’t remain immune to the recession. Last month, Moody’s Investors Service placed 14 of the 15 Turkish banks it covers on review for a possible downgrade, saying the weak economy “will continue to exert pressure on Turkish banks’ asset quality.”

One of the main reasons many analysts and investors want to see the government reach a standby agreement with the IMF is to ensure sufficient liquidity for Turkish banks and companies. At the end of 2008, private sector external debt amounted to $185.1 billion, of which banks accounted for $59 billion. Of the overall total, $61.6 billion matures this year and $51 billion in 2010, according to JPMorgan Chase. Until Lehman’s collapse, Turkish entities had easy access to international credit; they borrowed twice as much abroad in the first nine months of 2008 as they repaid in foreign debts. But since the collapse the ratio of borrowings to repayments, known as the rollover ratio, has fallen to about 90 percent.

Although their foreign borrowing has declined, Turkish companies and banks haven’t been squeezed as much as their counterparts in other CEE countries. What’s their secret? In the boom before the crisis, Turkish corporations built up huge war chests of unreported deposits in foreign accounts, and they have borrowed abroad using these deposits as collateral. “Unregistered inflows are large,” says JPMorgan Chase’s Cebeci. “And the Turkish government has been reluctant to engage in the fight against tax evasion.”

According to central bank statistics, between the end of November 2008 and the end of April 2009, unregistered inflows amounted to $18 billion. “These transactions were outside the capital accounts figures sent to us by the banks,” concedes Yilmaz, the central bank governor. “The banks don’t ask questions to individuals or businesses about where this money comes from.” He estimates that Turkish corporations still have about $30 billion in deposits abroad.

The lack of transparency involving these foreign accounts leads some analysts to question their reliability. “There is always a danger that such large unregistered inflows — if you don’t know where they come from — may not last,” says Kristin Lindow, a New York–based credit analyst who covers Turkey for Moody’s.

Although corporations have managed to roll over their debt, smaller businesses with no significant foreign deposits are experiencing difficulties. “Banks continue to lend to the usual suspects — the large multinationals and blue-chip corporates,” says Goeksenin Karagoez, a Paris-based credit analyst with Standard & Poor’s. “But the banks have grown a lot more cautious in lending to small and medium enterprises.”

Businesses, no matter what their size, have been hit hard by the recession. OYAK, the military pension fund and giant business conglomerate, saw its net income drop to Tl 1.9 billion in 2008, from Tl 2.7 billion in 2007, because of falling revenue and higher oil and commodity prices. (The group discloses only annual figures.) Among OYAK’s largest investments is a stake of slightly more than 50 percent in Ereg˘li Demir Çelik, or Erdemir for short — Turkey’s biggest steel producer. Erdemir’s net income dropped to Tl 211 million in 2008, from Tl 679 million in 2007. The company showed a Tl 137 million loss for the first quarter of 2009, compared with a Tl 219 million profit for the same period a year before, as domestic demand for steel plummeted, part of ten consecutive months — from August 2008 to May 2009 — of industrial contraction in the country.

The central bank points out that the year-on-year fall in industrial production has slowed, from a record 23.8 percent in February to 17.4 percent in May. Manufacturing capacity has risen, from 64.7 percent in March to 72.7 percent in June. Governor Yilmaz cites these figures as among the green-shoot indicators of a coming economic turnaround. But OYAK’s Ulusoy is having none of this optimism. Noting that exports fell 32.8 percent in the first half of 2009 compared with a year earlier and that automobile output plummeted 39 percent during the same period, he says, “I think this storm could last another five years.”

To get through it, OYAK is focusing more on financial investments and cost efficiency. The sale of its OYAK Bank to ING in 2007 at the top of the market earned the pension fund $2.7 billion. Returns from financial funds managed exclusively for OYAK’s military membership have added a further $2.5 billion, for a total cash pile of $5.2 billion. Ulusoy plans to use part of that money to buy a coal mine and an iron ore mine for Erdemir’s steel plants later this year or next. Unable to do anything about lower demand for steel, Erdemir hopes these purchases ensure stable, reliable supplies of raw materials. “Erdemir’s profits were dropping even before the crisis because of higher prices for scarcer natural resources,” Ulusoy says. “And it’s just going to get tougher.” To further contain costs, the company got its unions to agree in May to accept a 35 percent pay cut for as long as the crisis lasts in return for a promise from management not to fire anybody.

Unemployment in Turkey has already reached painful proportions. The official rate was 13.6 percent in May, but the real figure may be closer to 30 percent. Strict labor rules have led to the growth of a large informal economy, with many Turks working off the books. According to the World Bank, Turkey ranks 138th among 181 countries in the ease of hiring and firing workers, well behind the BRIC countries — Brazil, Russia, India and China — it aspires to join. “We expect unemployment to continue at high levels over the next months,” says Ulrich Zachau, the World Bank’s country director for Turkey.

That’s just one more argument in favor of an IMF agreement, supporters say. “We have learned some lessons, but old habits die hard and may resurface in times of difficulty,” says Yilmaz. “That’s why we think that the discipline and reassurance that another IMF program brings are more important than the amount of money it would provide.”

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